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To All My Investor Friends: Happy New Year 2007
2006 for me was a year of change (maybe that is true for all years!) It isthe year that my son left home and into his own condo. It is a year that sawthe passing of my wife Susan’s mother, Renae. My daughter turned 16 and isnow driving her own car. Such changes give me perspective on life in generaland make me more appreciative for the gifts I have been given for therelatively short time I am here.This is my sixth year writing an annual financial newsletter cum forecast.It is my pleasure each December to work on this and share my ideas with you.Whether or not you use any of the information and profit from it.
Here is what I said in last year’s newsletter in January 2006 (all my previous newsletters are posted on my Wealth-Ed.com website for your review):
To summarize the theme for 2006: “it is all about Bernanke”. The big changethis year will be what the new Fed Chairman decides to do with the FederalFunds overnight rate.
I think this two-sentence analysis for the coming year, made two monthsbefore Bernanke took over Chairmanship, was very accurate. 2006 HAS been allabout Bernanke. But what has surprised most investors and me is howsuccessful Bernanke has been in managing the GNP and housing growth slowdownwithout incurring either run-away inflation or a recession. I had factoredin a high likelihood that he would not pull this off and had become verydefensive by May. I expected the Fed to overshoot on the side of tightening,precipitating a significant recession (which would have made my forecast of astock market low of DOW 8500 a reality). This is what previous Feds havedone in similar circumstances, where growth, speculation (real estate in thiscase) and energy costs are above upper acceptable limits. Given myunderestimation of Bernanke’s Fed, I still did all right on my marketforecast:
Based on the above historical and current events analysis here is my game plan for 2006: A range of 8500 to 11,500 for the DOW (just about the same as2005 and the third year in a row for this forecast range), 900 to 1500 for the S&P500, 1800 to 2500 for the NASDAQ Composite. I think that the weaknessthis year will come in the first half of the year with a bottom during thesummer coinciding with acknowledgement of the mild recession brought on by short term rates between 5% and 6%. After that, the pre-election fiscalstimulus, and the end of interest rate increases coming into sight, willcause a market rally during the fall and early winter, culminating in asignificant “Santa Claus” rally which went missing this past year (2005).
Other than being too conservative on the upper range for the DOW Industrials,I would have to say this overview / prognostication was spot on, with highestprices at the end of the year (as of today, Dec. 27, DJI = 12,410, SP500 =1415 and NDQ COMP = 2414). But I will admit to you that I didn’t believe myown words with enough conviction to get back into the market in a big way atthe “summer lows” in July. As often happens, in the heat of the moment, itseemed that the problems in the economy (namely a weakening economy withinverted yield curve, Israel-Hezbollah trouble and high energy prices) wereconspiring to delay the recovery. Also, we did not really get a “mildrecession” but only a slowdown in GNP growth, which continues today in the 4
th
quarter of 2006 and into 2007. So, I did not benefit like I could have had I
 
just reread my letter and acted on its words of advice. I may have given up10% of return for the year on my portfolio, but was very safe in doing so.Peace of mind can be worth lost opportunity (at least that is what I amtelling myself).Last January, I was also very convinced of a real estate (housing)correction. Speculating on real estate had become a national past time.Pricing in many locations, especially on the East and West coasts, had losttouch with reality. If rising interest rates didn’t do the trick (at thetime, there was speculation that Bernanke would raise Fed Fund rates to 6%),then low affordability would. There are logical limits on the percent ofincome that a family can pay for mortgage payments and that would eventuallystop the housing price increases. I cited a new book by Dr. Robert Shillerthat provides academic research behind the theory of real estate pricing:
Dr. Robert Shiller (Yale University) precisely defined very long run realestate growth at 1% over inflation in his new book, “Irrational Exuberance2”…. This number was arrived at by extensive historical research conducted by a squad of graduate students…. Second, I believe government and industry data from the last couple months (nearly 20 year high in housing inventory onthe market, “days on market” at over 60 days, another 20 year high), showsthat the real estate bubble is in the process of being popped. This is duein large part to the commitment of the Fed to raise interest rates and discourage excess lending. We will know more next year at this time how severely the real estate markets turn down, which geographic markets are mostaffected and whether all of this precipitates a recession.
This observation / prediction has also proved accurate, though again, theBernanke Fed has done a better job containing the real estate market troublethan I would have guessed based on historic examples. While the very shortterm Fed Funds rate has been maintained at 5.25%, there has been noaccompanying liquidity squeeze / credit crunch like in 1990-91 or the early1930s. This has made it relatively easy to obtain a mortgage for refinancingadjustable or Option ARMs. And because of the re-circulation of US Dollarsearned by the Chinese and other net-export countries back into our economy,the 10 and 30 year T-Bond interest rates most important to the mortgagemarket, have been held relatively low. All this suggests that in the absenceof some large but unpredictable global financial “accident”, the Fed andother central banks will be successful in managing economic growth andcredit. But if there is an “accident” where will it originate?The unwinding of the housing bubble has yet to run its course. Only now thesub-prime ARM and Option ARM mortgages are adjusting that financed realestate speculation and marginal borrowers the past 3-4 years. Most sub-primeborrowers were forced to exotic mortgages by the high price of real estateand their inability to qualify for standard fixed rate mortgages (which goesto the point of housing affordability as a lid on the market). Some say thatpeople with ARMs can always refinance to a fixed rate product at market rate(now about 6.25% for 30 years) if there is a need. But the flaw in the logicis that it took a low 2% interest rate ARM to qualify those borrowersoriginally. Now, they must requalify at the higher rate, and most likelywith a lower assessed value on their property. Those borrowers who cannotmeet the higher standards will be forced to default on their mortgages.Because housing real estate is so illiquid (hard to sell), and because mostpeople will do anything to avoid foreclosure on their home and loss of alltheir principal, mortgage defaults are a slow moving train. It will take up
 
to two more years to see what damage the housing bubble will cause. If theeconomy holds up, the damage may be light. However, if there is a recession,even mild resulting in job losses, the damage to the real estate market andthe economy will be much worse.It is the slow motion bursting housing bubble that might precipitate a muchdeeper economic crisis than most are forecasting. Watching for an increasein foreclosures will signal the crisis too late. Instead, watch the monthlyeconomic data on joblessness / unemployment rate and consumer confidence. Ifthose become negative the next 3-4 months, then we will have a much worsecorrection.To avoid the pain of such a steep correction, my allocation today is to hold50% cash and other short term funds, 15% equities, mostly large cap withoutany housing exposure (exclude large banks that today seem cheap and have highdividends, like Washington Mutual or Wells Fargo), 15% North American basedoil and gas trusts and 20% international equities, where economic problemswill likely be less severe than the USA.
Eight things to consider in 2007 for financial security
(2006 suggestions inItalics for comparison
):
I believe this upward trend in commodities and gold will continue for sometime. It has only just started. The gold cycle is similar to the oil cycle.Both benefit from both being valued as “hard assets” with intrinsic historicvalue, even though the values are different to homo sapiens. As our tradeand budget deficits continue to weaken the dollar, it becomes less attractiveas the world’s “reserve currency” and gold becomes more attractive. Thischange in thinking will take years to play out as gold continues its march to$2000 per ounce.
1. After a great start to the year, gold and precious metals flattened outduring the second half, along with other commodities. I continue to holdgold in a mutual fund, the Vanguard Precious Metals and Gold fund (VPGMX). Ihave also bought mining companies from time to time, or speculated in theiroptions, such as Yamana (AUY) or Anglogold (AU). Long term, gold continuesto look good for all the reasons given in previous years. This is a longterm story, and while gold may not head straight up, it will continue toappreciate in the face of a weakening US currency.
Stay conservative (Still True and will be until equities are againcheap…below 10x current earnings); I still think this is not a time for themarket to rally. The market price to earnings ratio is not anywhere near atypical low in respect to valuation, at the current 17 or 18 times (evenhigher once employee stock option expenses are deducted from earnings, whichwill be required by July 1, 2006). But a 10x earnings factor would require asignificant inflationary environment. I am not as convinced of runaway inflation as last year, especially with Ben Bernanke as Fed Chairman. So Iam changing the definition of a “cheap stock market” to 13 times in a 5%inflation environment.
2. The stock market action in the past 4-5 months has suggested that anextended rally may be around the corner. Still, the market has come a longway off the summer bottom and it needs to take a little time off. Also, theeconomy continues to cool and the market will not advance until economicgrowth changes direction (or more accurately, until the market anticipatesthe change). USA GNP growth is currently at around 2% and still declining
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